Book Review: Unconventional Success

Unconventional Success: A Fundamental Approach to Personal Investment
By David F. Swensen

Swensen, CIO of Yale University and the author of Pioneering Portfolio Management, reveals why the mutual fund industry as a whole does a disservice to the individual investor. Soft money, 12b-1 fees, overtrading, market timing, and other management practices lower performance and virtually guarantee that most mutual fund returns will fall short of their benchmark, such as the S&P 500.

Furthermore, for-profit mutual fund companies have a fiduciary obligation to their stockholders, not to their investors, and this relationship "inevitably resolves in favor of the bottom line." Swensen is also highly critical of the Morningstar rating system, which only causes investors to chase hot performing funds and managers.

He advises considering alternatives to the for-profit mutual fund industry, including Exchange Traded Funds and not-for-profit financial institutions such as Vanguard and TIAA-CREF. He highly recommends that as an individual, you should play a more active role in your financial future. This includes periodic portfolio evaluation and rebalancing, to ensure that your asset allocation remains diversified and suits your investment time line.

Credit: Booklist

Market Summary

The first quarter of 2006 has started out with a bang! Nearly every sector except utilities, one of last year’s hot sectors, is up. You could have invested in just about anything and made money (and hopefully you did). US stocks, both large and small; international and emerging markets, all posted excellent returns. The S&P 500 index increased 3.7% for the quarter, more than all of 2005!

In fact the S&P 500 earned more last quarter than the average annual return of the index over the past 5 years. Small and medium sized stocks continued to out perform their larger brethren by a large margin. The Russell 2000 index of small stocks rose nearly 14% setting a new record high. “Value stocks” outperformed “growth stocks” nearly 2 to 1 for the quarter according to Morningstar, Inc.

During the first quarter, the Federal Reserve, under new Fed chairman Ben Bernanke, continued increasing short term rates. Two rate hikes of 1/4% were added to the previous 13, pushing the prime rate up to 7.75%. This is the index tied to most home equity loans. In my year end summary, I predicted the Fed would stop at this level. However, recent Fed comments like this, "some further policy firming may be needed.” indicate the fed will continue increase rates at least one more time.

When To Harvest Stock Options

Employees with stock options are faced with a tough dilemma. In order to convert the option into real value, they must cash it in. If they cash the option in, they realize the intrinsic value of the option, the difference between the option price and the current market value. This removes the risk of having the option become worthless. However, by exercising, they lose any remaining time value left in the option and they incur the tax liability.

There are a variety of strategies designed to deal with this dilemma.

1. The “Need Approach”: Cash in the option when you need the money. This clearly does nothing to balance investment risk and reward

2. The “Prediction Approach”: Many optionees and some advisors, try to time the harvesting of the stock based on some prediction of how the stock is going to perform. The reliability of such perditions is not possible. This approach often fails and sometime with spectacularly disastrous results.

3. “Timeline Approach”: There are basically three options with this approach:

a. Exercise as soon as possible. In this case, exercise options as soon as they vest as long as you are in the money. This approach is conservative but wasteful because you will lose all of the time value of the option

b. Exercise as late as possible. In this case, options are exercised just before they expire. This approach avoids wasting any of the options value but leaves the optionee exposed to risks of stock devaluation for a very long period of time.

c. Select a random period of time such as 1 year before expiration. The idea here is to minimize the risk and still receive some time value for the option .

4. A Balance Approach: This approach provides the greatest possible return for the least risk. It is also different for just about everyone. The approach here is to convert a high-risk investment, into a normal diversified investment, while not losing a large portion of its value. Thus, converting the stock in the value to be gained is significantly larger than the time value that is lost. Thus, options deep in the money should be cashed sooner than those with smaller gains. One also has to take into account the value of the option relative to ones overall net worth. Options representing large portions of net worth should be exercised sooner.

Tax Implications for Nonqualified Stock Options
If a stock is exercised after vesting, then the optionee reports compensation income equal to the amount by which the stock value exceeds the exercise price. This amount is now included in the tax basis of the stock, so they have a basis equal to their fair market value. Any subsequent change in value will result in capital gain or loss, which will be long-term if the sale occurs more than a year after the option was exercised.

Most optionees exercise and hold for a year to take advantage of long-term capital gains treatment. This however exposes them to “capital loss whipsaw”. Imagine you own PSI Net with a $100,000 gain at the time of exercise. The stock proceeds to go down $90,000 before the shares are sold a year later. Now you will report $100,000 of in compensation income with a capital loss of $90,000. You can only deduct $3000 of the capital loss and will end up paying ordinary income taxes on $97,000 even though her true profit is only $10,000!

The benefits of exercising and holding nonqualified stock options do not outweigh the risks associated with holding them over time.

Tax Implications for Incentive Stock Options
AMT tax has made it more difficult for those with ISOs who’s with income between $150,000 and $380,000. This is because the AMT tax increases the tax rate for those income brackets. Individuals making more than $382,000 already are paying higher taxes and are not affected by AMT (ISO impact). Options are to exercise and sell, exercise and hold for one year in hopes to reduce the tax liability, or a combination of the two.

There is a significant amount of risk in holding the stock for a year in hopes of reducing the tax on the gain. This is due to the fact that you will pay tax in the year you exercise and may lose value in the stock by holding it an additional year. To get the best of both worlds, possible capital gains treatment with lower risk, consider selling 65% of the stock immediately and holding the remainder for a year. This allows you to take some of the risk off the table and still reap the benefit of the capital gains tax. Ratios will vary depending on the amount of the gain and the tax credit. It is important that you consult your tax advisor before making any decisions as they relate to non qualified and qualified stock options.

Source: FPA Seminar on Stock Option Planning for Corporate Executives by Kay Thomas, Founder of the National Board of Certified Option Advisors.

Federal Reserve Forum

The Federal Reserve has now completed 15 consecutive 1/4 rate increases since June of 2004. This means that if you have a home equity line, your rate has nearly doubled from 4% to 7.75% over the past year and half. According to Tom Millon of the Capital Markets Cooperative, “The futures market placed 100% probability on a 5.00% funds rate in May, and 40% odds on 5.25% shortly thereafter in June. A week ago, the odds of a June hike were virtually nil. Rising commodity and energy prices, rising employment, rising gold, and a growing world economy create ripe conditions for the potential to add to inflationary pressures."

The Value of Asset Allocation: A Case for Indexing

Large cap stocks or mutual funds are core to any portfolio. Allocations to this asset class range from 15% to 35% depending on risk tolerance. (If you have more than this, you may want to evaluate your portfolio!) Most of us have seen the articles featured in the Wall Street Journal where a chimpanzee throwing darts at a stock page tends to outperform Wall Street’s brightest managers. Over the past 20 years there have been numerous studies on the value of selecting managed mutual funds vs. simply buying an index fund.

An index fund is mutual fund designed to mimic the returns of a given stock market index such as the S& P 500. For example, the Schwab Institutional S & P 500 Index fund simply utilizes a computer model to purchase all of the US’s largest 500 stocks in a weighting equal to their market cap.

According to a recent article in the Journal of Financial Planning by Thomas P. McGuigan, CFP, the large cap fund index (S& P 500) outperformed managed mutual funds 72% to 84% of the time over rolling 5,10, 15 and 20 year periods since 1993. The study concluded that the longer the period of time, the more likely the index beat the managed funds. The percentage of mutual funds that outpaced the index fund was only 10.59%. Thus, only 18 of 171 mutual funds outperformed the index fund over 20 years. The majority of out performers, 12 out of 18, only outperformed by 1% or less. This study did not take into account all the funds that are no longer in existence. If this figure was included, the percentage of funds that beat the index would be even lower. The study also found that the cost of selecting the wrong fund was very high.

The majority of the underperformers (113 funds), missed the mark by 1 percent or more. In my opinion, these odds are just not worth the risk.

Why is it that a chimp can outperform a manager in large cap stock selection? The answer lies in market efficiency, managed fund expenses and taxes. The US stock market and particularly the large cap stocks are nearly perfectly efficient. This means that the markets impound information into prices so well that the analysis of publicly available information will not produce excess returns. Thus manager out performance is simply luck rather than skill.

In addition to market efficiency, fund costs have a huge impact on performance. Fund costs include expense ratios, commissions, bid ask spreads and impact costs. Expense ratios are the cost of staff and overhead. Commissions and bid ask spreads are the actual costs of trading stocks. Impact costs relate to the expense associated with liquidating a large position in a particular stock. These expenses range form 1 to 2 percent per year for all funds.

On the other hand, an index fund has considerable lower expenses. For example, the Schwab Institutional S &P 500 Index fund mentioned above has a total expense ratio of just .22%. This gives the index fund a considerable advantage over its peers. Not only do managed funds have to beat the index, they must also cover their expenses. If the case above for indexing is not powerful enough, consider the impact of taxes. Managed portfolios generate nearly twice as much tax liability as index funds.

If all of the hold true for large cap stocks, what about smaller cap funds and international funds? While fund costs for these asset classes are actually higher, markets are less efficient giving some managers the edge. I generally used index funds for large cap portfolios and best in class institutional money managers for other asset classes.

Book Review: The Intelligent Asset Allocator

The Intelligent Asset Allocator
By William Bernstein

"As its title suggest, Bill Bernstein's fine book honors the sensible principles of Benjamin Graham in the Intelligent Investor Bernstein's concepts are sound, his writing crystal clear, and his exposition orderly. Any reader who takes the time and effort to understand his approach to the crucial subject of asset allocation will surely be rewarded with enhanced long-term returns."
– John C. Bogle

Founder & Former Chief Executive Officer, The Vanguard Group
President, Bogle Financial Markets Research Center
Author, Common Sense on Mutual Funds

Book Review: The Lexus and the Olive Tree

The Lexus and the Olive Tree: Understanding Globalization
By Thomas Friedman

One day in 1992, Thomas Friedman toured a Lexus factory in Japan and marveled at the robots that put the luxury cars together. That evening, as he ate sushi on a Japanese bullet train, he read a story about yet another Middle East squabble between Palestinians and Israelis. And it hit him: Half the world was lusting after those Lexuses, or at least the brilliant technology that made them possible, and the other half was fighting over who owned which olive tree.

Friedman, the well-traveled New York Times foreign-affairs columnist, peppers The Lexus and the Olive Tree with stories that illustrate his central theme: that globalization--the Lexus--is the central organizing principle of the post-cold war world, even though many individuals and nations resist by holding onto what has traditionally mattered to them--the olive tree.

Problem is, few of us understand what exactly globalization means. As Friedman sees it, the concept, at first glance, is all about American hegemony, about Disneyfication of all corners of the earth. But the reality, thank goodness, is far more complex than that, involving international relations, global markets, and the rise of the power of individuals (Bill Gates, Osama Bin Laden) relative to the power of nations.

No one knows how all this will shake out, but The Lexus and the Olive Tree is as good an overview of this sometimes brave, sometimes fearful new world as you'll find. --Lou Schuler

Book Review: Pioneering Portfolio Management

Pioneering Portfolio Management: An Unconventional Approach to Investment

by David F. Swensen

During his fourteen years as Yale's chief investment officer, David F. Swensen has transformed the management of the university's portfolio. Largely by focusing on nonconventional strategies, including a heavy allocation to private equity, Swensen has achieved an annualized return of 16.2 percent, which has propelled Yale's endowment into the top tier of institutional funds. Now, this acknowledged leader of fund managers draws on his experience and deep knowledge of the financial markets to provide a compendium of powerful investment strategies.

Swensen presents an overview of the investment world populated by institutional fund managers, pension fund fiduciaries, investment managers, and trustees of universities, museums, hospitals, and foundations. He offers penetrating insights from his experience managing Yale's endowment, ranging from broad issues of goals and investment philosophy to the strategic and tactical aspects of portfolio management. Swensen's exceptionally readable book addresses critical concepts such as handling risk, selecting investment advisers, and negotiating the opportunities and pitfalls in individual asset classes. Fundamental investment ideas are illustrated by real-world concrete examples, and each chapter contains strategies that any manager can put into action.

At a time when it is becoming increasingly difficult to cope with the relentless challenges provided by today's financial markets, Swensen's book is an indispensable roadmap for creating a successful investment program for every institutional fund manager. Any student of markets will benefit from Pioneering Portfolio Management.

Credit: Barnes and Noble

The Perfect Storm; Bubble Trouble

A friend of mine recently asked me if I were interested in going “in with him and some of his neighbors” to buy some townhouses to “flip for a profit”. They were forming a partnership in order “to get in on some of the hot real estate deals” that are now available. These were not traditional real estate investors but successful businessmen in the cable industry. Another friend said she doubled her investment on a second home she purchased at the beach less than a year ago. A few others have purchased speculative condos and are “hoping to make a killing”.

It all reminds me of 1989, the year I purchased my first home. The market was red hot and interest rates were on the rise. I couldn’t wait to get into the real estate market so I could enjoy some of the appreciation everyone else was realizing. I purchased the home for $289,000. Less than three years later, I listed it for $262,000, a drop of nearly 10%. After fix up and closing costs, I had to write a check for $14,000. Most of you will remember this time when rates were increasing, housing prices were falling, and the stock market was stagnant. Is this what the next 3 years have in store for us? As financial planners, it is our job to see through the noise and lead our clients down the safer path.

Real Estate Reaches Record Appreciation Levels
Recently, the Office of Federal Housing Enterprise Oversight, the government entity charged with ensuring the capital adequacy and financial safety and soundness of FNMA and FHLMC, published its House Price Index for 2004. For the 5th consecutive year, housing prices have increased by more than 7.5% nationwide. National housing prices increased by 10.24% in the 2004. Here are the to 10 states ranked by appreciation over the past 5 years:


(click to enlarge)

Conundrum
The Federal Reserve has increased short-term rates at a “measured pace” 8 times since June of 2004. Yet long-term rates such as mortgages remain below their levels of 1 year ago. Fed Guru Greenspan recently referred to the current low long term interest rates as a “conundrum” (which by the way is also a great white wine made by Caymus Vineyards)! Fed tightening, higher core inflation, near record oil prices, lower dollar, record federal budget deficit, and above trend economic growth create the perfect storm for higher long term rates and an immediate halt to appreciating property values.

Testifying before the House Financial Services Committee last month, Greenspan stopped short of calling home buyers “irrationally exuberant”, but stated "I think we're running into certain problems in certain localized areas. We do have characteristics of bubbles (in those markets) but not, as best I can judge, nationwide." Publicly traded homebuilders stocks fell 10% on the comment.

Home Sales Slowing
According to Merrill Lynch economist David Rosenberg, “the backlog of unsold homes has risen steadily, and in January approached a five-year high of 4.7 months supply. However, raw data, excluding seasonal adjustments indicate that the backlog has reached six months, which would mark an eight-year high.” While our local markets remain strong, this may be the last rush to purchase property before rates increase by too much.

Home Appreciation Outstrips Personal Income
“Median house prices have risen about 30% since March 2001, well ahead of an 11% gain in personal income”, says Michael Youngblood, head of asset-backed research at Friedman Billings & Ramsey.

Speculation on the Increase
Meanwhile, “unfettered access to easy money has inflated home prices nationwide, particularly on the coasts, and lately has let to an upsurge in speculative buying.” says Kopin Tan of Barron’s. Just as with the stock bubble in 2000, recent increases in speculative buyers and property flippers have driven up values in many urban areas like Washington DC.

“Household real-estate assets now equal nearly 14% of Gross Domestic Product, the highest proportion in two decades and eerily close to the ratio of household mutual fund and equity holdings relative to GDP at the stock market’s peak in 2000.” says Kopin Tan of Barron’s.

David Berson, the chief economist for Fannie Mae, observed in his weekly commentary that investor ownership of housing hasn't been this high since the late 1980s, which led to a crash in housing prices. "Many analysts think that a high investor share in the Northeast and California helped exacerbate the housing downturn that happened during the 1990-1991 recession”.

Bubble

Yale University economist Robert Shiller, author of "Irrational Exuberance," the 2000 best-selling book about the '90s stock-market bubble, said the only similar housing boom in U.S. history was when GIs returned home from World War II, lifting a depressed market. The latest addition of “Irrational Exuberance includes a chapter on the current real-estate trend.He thinks the current boom is a "classic bubble" because people keep buying houses they know are too expensive because they expect prices to rise even higher.

Conclusions
Ultimately it will be the level of long term interest rates that will create a local or national housing bubble. If rates exceed 6%, expect a 10% correction across the board. Larger homes will most likely be hit harder. If rates stay below this threshold, we may still see some localized drop in values in the higher end prices of homes in localized areas. The question is when?
As financial planners, it is our job to help our clients steer clear of disaster. Most real estate acquisitions are highly leveraged. This leverage works against you in a falling market. If your clients have an over allocation of real estate, it may be time to rebalance.